The UK Emissions Trading Scheme Free Allocation Review Consultation closes on 11th March 2024. Click here for a response form on the GOV.UK consultation page:
This consultation focuses on reducing the risk of carbon leakage by adapting the UK ETS Authority’s approach to free allocation and tailoring it to the UK context.
The current approach to free allocations for stationary installations under the UK ETS is heavily tied to the EU ETS methodology. It is therefore not reflective of the distribution of the UK’s industrial sectors.
The consultation proposes options for changes to the free allocation methodology including:
- The approach to accounting for activity.
- The way we assess carbon leakage risk.
- Additional aspects of methodology such as consideration of decarbonisation technologies and conditionality.
- Technical proposals to improve operability and deliverability of the scheme.
The UK ETS Authority aims to implement any changes in 2026; the start of the second allocation period of UK ETS Phase 1.
What is carbon leakage?Carbon leakage refers to the movement of production and associated emissions from one country to another due to different levels of decarbonisation effort through carbon pricing and climate regulation. As a result of carbon leakage, the objective of decarbonisation efforts – to reduce global emissions – would be undermined.
What is free allocation?
Free allocation of UK ETS allowances is the main policy instrument through which carbon leakage risk is currently addressed in the UK. The provision of free UK ETS allowances means that an operator needs to buy fewer allowances to cover their emissions, in effect, reducing the carbon price they pay and mitigating the risk of carbon leakage.
Preliminary Free Allocation =
Historical Activity Level × Benchmark × Carbon Leakage Exposure Factor.
Proposal 1: Changes to Activity Level
In the first allocation period of UK ETS Phase 1 (2021-2025), an activity level change will be triggered if an operator’s average activity level in any two-year period increases or decreases by 15% or more relative to their historic activity level (HAL). Free allocation is recalculated for the scheme year following the two-year period in which the threshold was exceeded, using the two-year average in place of HAL.
HAL is defined as the average activity level over the baseline years for a given allocation period (e.g., for the 2021-2025 allocation period the baseline years were 2014-2018).
The UK ETS Authority proposes introducing a dynamic allocation. Initial free allocation of allowances would be based on either a historical baseline as seen in the first allocation period of UK ETS Phase 1, or calculated using a rolling period that would more accurately reflect recent activity levels (e.g., the average of the most recent two years for which data is available, such as 2023/24 for 2026).
Going forwards, free allocation would then be adjusted annually if necessary. Under a dynamic allocation approach there would be no 15% threshold for ALCs.
Energy efficiency is a key tool used to determine the validity of changes in activity for heat fuel benchmarks. A dynamic allocation would still require the use of energy efficiency data and will likely still require reference to a fixed five year historical baseline.
Proposal 2: Updated Benchmarks
The UK ETS currently uses the same benchmark values as the EU ETS Phase IV. Data from UK installations was not used in updating benchmarks from EU ETS Phase III to Phase IV.
The UK ETS Authority proposes to update benchmarks for the next allocation period based on UK installation data only. Using UK data in the update would lead to ARRs and benchmarks that reflect improvement rates achieved by UK installations.
Proposal 3: How to Assess the Risk of Carbon Leakage
The UK ETS Authority proposes to maintain the current methodology used to assess carbon leakage risk. Risk is calculated based on trade intensity and emissions intensity.
Proposal 4: Application of the Carbon Leakage Exposure Factor (CLEF)
The UK ETS Authority proposes to phase out free allocation, to those not on the carbon leakage list, by 2026 instead of 2030. Doing so would mitigate the risk of triggering the Cross-Sectoral Correction Factor and align free allocation legislation with that applied to the aviation sector.
The UK ETS Authority also proposes to introduce a tiered free allocation system. The percentage of free allocation received would be determined by which tier the industry resides in. The proposed tiers are Top Risk Tier: 70%-100%; Medium Risk Tier: 40%-70%; Low Risk Tier: 10%-40%; and No Risk Tier: 0%.
Proposal 5: Tiering the Cross Sectoral Correction Factor
The UK ETS Authority proposes to introduce a tiered Cross-Sectoral Correction Factor. Instead of applying an even reduction in free allocation across all installations, the reduction could be weighted based on the carbon leakage risk of different sectors – with smaller reductions for those at most risk.
If you have any questions on the information provided within this update, please contact us.